Ratio Analysis

Depending on the type of business and to arrive at decisions, various

Activity Ratios can be used. Let us now look at activity ratios with
formulas and examples.

#1 – Inventory Turnover Ratio

For a business that holds inventory, this activity ratio formula shows how
many times the inventory has been sold out completely in one
accounting period.

Inventory Turnover Ratio = Cost of Goods Sold / Average Cost of

Inventory
Example:

The cost of goods sold for Binge Inc is $10,000, and the average
inventory cost is $5,000. The Inventory Turnover Ratio is calculated as
below:

= $10,000 / $5,000

Inventory Turnover Ratio = 2

It means that the inventory has been sold out twice in a fiscal year. In
other words, it takes 6 months for Binge Inc. to sell its entire inventory.
Too much cash into inventories is not good for a business; hence,
necessary measures need to be taken to increase the inventory turnover
ratio.

#2 – Total Assets Turnover Ratio

Total Assets Turnover Ratio calculates the net sales in comparison with
its total assets. In other words, it depicts the ability of a business to
generating revenue. It helps investors to understand the efficiency of
businesses in generating revenue using their assets.

Total Assets Turnover Ratio = Sales / Average Total Assets.

Example:

PQR Inc. generated revenue of $8 billion at the fiscal year-end. The total

assets at the start of the year were $1 billion and, at the end of the year,
$2 billion.

Average Total Assets = ($1 billion + $2 billion) / 2

= $1.5 billion

Total Assets Turnover Ratio is calculated as below

= $8000000000 / $1500000000

Total Assets Turnover Ratio = 5.33

A higher Total Asset Turnover Ratio depicts the efficient performance of

the business.

#3 – Fixed Assets Turnover Ratio

Fixed Assets Turnover Ratio measures the efficiency of a business in

utilizing its fixed assets. It shows how the fixed assets are being utilized
by the business to generate revenue. Unlike the total Assets turnover
ratio that focuses on the total assets, the fixed assets turnover ratio
focuses only on fixed assets of the business being utilized. When the
fixed assets turnover ratio is declining, it is a result of over-investment in
any fixed assets like plant or equipment, to name a few.
Fixed Assets Turnover Ratio = Sales / Average Fixed Assets.
Example:

Net sales of Sync Inc. for the fiscal year were $73,500. At the beginning
of the year, the net fixed assets were $22,500, and after depreciation
and addition of new assets to the business, the fixed assets cost to
$24,000 at the end of the year.

Average Fixed Assets = ($22,500 + $24,000) / 2

Average Fixed Assets= $23,250

Fixed Assets Turnover Ratio is calculated as below

= $73,500 / $23,250

Fixed Assets Turnover Ratio = 3.16

#4 – Accounts Receivables Turnover Ratio

Accounts Receivables Turnover Ratio depicts how good a business is at

giving credit to its customers and collecting debts. For calculating the
accounts receivables turnover ratio, only the credit sales are taken into
consideration and not the cash sales. A higher ratio indicates that the
being paid by the customers on time, which helps to maintain the cash
flow and payment of the business’s debts, employee salaries, etc. on
time. It is a good sign when the accounts receivables turnover ratio is on
the higher side since the debts are being paid on time instead of writing
them off. It shows a healthy business model.

Account Receivables Turnover Ratio = Net Credit Sales / Average

Accounts Receivables.
Example:
Roots Inc. is a supplier of heavy machinery spare parts, and all of its
customers are major manufacturers, and all of the transactions are
carried out on a credit basis. The net credit sale for Roots Inc. for the
year ended was $1 million and the average receivables for the year were
$250,000.

The accounts receivables turnover ratio can be calculated as below

= $1,000,000 / $250,000

Account Receivables Turnover Ratio = 4

It means that Roots Inc. is able to collect its average receivables 4 times
a year. In other words, the average receivables are recovered every
quarter.

One of the key factors in ratio analysis is the comparison to the

benchmark companies of an industry. This type of financial analysis can
be useful to both internal management and outsider analysts of the
company, as it provides significant insights from the financial
statements.

As with any financial analysis technique, there are several limitations of

ratio analysis. It is crucial to know these limitations to avoid misleading
conclusions.

What are the limitations of ratio analysis?

Some of the most important limitations of ratio analysis include:

 Historical Information: Information used in the analysis is based

on real past results that are released by the company. Therefore,
 ratio analysis metrics do not necessarily represent future company
performance.
 Inflationary effects: Financial statements are released periodically
and, therefore, there are time differences between each release.
If inflation has occurred in between periods, then real prices are
not reflected in the financial statements. Thus, the numbers
across different periods are not comparable until they are
adjusted for inflation.
 Changes in accounting policies: If the company has changed its
accounting policies and procedures, this may significantly affect
financial reporting. In this case, the key financial metrics utilized in
ratio analysis are altered and the financial results recorded after
the change are not comparable to the results recorded prior to
the change. It is up to the analyst to be up to date with changes to
accounting policies. Changes made are generally found in the
notes to the financial statements section.
 Operational changes: A company may significantly change its
operational structure, anything from their supply chain strategy to
the product that they are selling. When significant operational
changes occur, the comparison of financial metrics before and
after the operational change may lead to misleading conclusions
about the company’s performance and future prospects.
 Seasonal effects: An analyst should be aware of seasonal factors
that could potentially result in limitations of ratio analysis. The
inability to adjust the ratio analysis to the seasonality effects may
lead to false interpretations of the results from the analysis.
 Manipulation of financial statements: Ratio analysis is based on
information that is reported by the company in its financial
statements. This information may be manipulated by the
company’s management to report a better result than its actual
performance. Hence, ratio analysis may not accurately reflect the
true nature of the business, as the misrepresentation of
information is not detected by simple analysis. It is important that
an analyst is aware of these possible manipulations and always
complete extensive due diligence before reaching any conclusions.